Divorce Financials: Lifestyle Analysis in Family Law Cases

This article was originally published in the American Journal of Family Law (Volume 32, Number 2 / Summer 2018)

Determining the income of the parties to a divorce or child custody case is critical, as it affects spousal support and child support. It may also affect the division of assets, particularly if there are income-producing assets to be divided. In each of these instances, properly determining the income of the party is critical to getting a fair and equitable settlement, maintenance award, or child support award. Until you have accurate numbers, the attorney may find it very difficult to decide what is fair or in the best interest of the client.

It is not unusual for a closely held business to suspiciously suffer from declining revenue and profits once a family law case comes to fruition. The spouse in control of the business may state that the economy is negatively affecting the business, or that other conditions such as competition or changing technology are the cause for a decline in the financial condition of the business. Is it a coincidence that a thriving business just happens to suffer a decline at the precise time that a family law case is initiated? Of course it is no coincidence, and the numbers must be investigated to present a true financial picture to the court.

There are many situations in which it’s hard to determine exactly what the income is for some of the following reasons:

Poor bookkeeping

Failure to disclose financial documents and details

Lying about the finances

Hidden income (under the table cash sales, etc.)

Commingling of personal and business finances

Complicated businesses

Movement of funds between multiple business interests

Intentionally confusing or incomplete paper trails

Access Denied

Universally, the most problematic part of thoroughly evaluating the income and assets of the owner of a closely held business is the lack of financial documentation. The “in” spouse often obstructs attempts to examine the financial condition of the business, citing confidentiality concerns, voluminous documents, or other red herrings.

If documents are produced, they are usually provided piecemeal, so a complete financial picture can never be evaluated. It is important to track the document production and demand that missing statements be provided. Even one missing statement could drastically change the case, as that single missing statement might contain a transaction that could lead to the discovery of hidden assets or income.

It is not uncommon for documents to be discarded, destroyed, or purposely withheld. Even when substantial documentation is produced, there may still be holes in the financial picture due to things like unreported income and cash sales. Unreported employee perks or personal expenses paid by a company are additional items that may be missing from the financial picture provided by the other side.

This is where the forensic accountant can be very valuable to the divorce attorney. A properly performed lifestyle analysis can go a long way toward proving the existence of income and assets. It is important that your expert be a true expert, however, with a strong account background, preferably holding a CPA license, having provided expert testimony on a regular basis, and being well-versed in the nuances of lifestyle cases in family law.

Lifestyle Analysis

Lifestyle analysis is not only used in family law cases. It is often used by government agencies and defense counsel in cases such as money laundering and tax evasion. Wherever there is potential for unreported income, a lifestyle analysis may be one way to prove that the target had undisclosed earnings. This method of analyzing an individual’s income can be called the “expenditures method,” signifying the analysis of a person’s spending patterns relative to known sources of funds.

The lifestyle analysis attempts to quantify someone’s living expenses in comparison to known sources of income. If there are differences between the living expenses and the known income, they may be attributed to concealed income. The goal is to compute the cost of the lifestyle of the target and determine whether the reported income is sufficient to fund this lifestyle. In a simple lifestyle analysis, we add the known expenses such as groceries, mortgage, auto lease, insurance, credit card payments, income taxes, and the like. The total spending is then compared to known sources of funds, such as wages, bonuses, dividends, gifts received, and loan proceeds. The key is to include all sources of income and all the ways the subject may be spending money.

If the spending during the period under analysis exceeds the known funding sources, then it is likely that there is another source of income. The logic is simple: The money has to come from somewhere. The forensic accountant must continue to search for other sources of income that could explain the difference. Any remaining unexplained difference likely represents unreported income.

For example, how does an attorney who reports income of $35,000 from his law practice on his tax return manage to purchase three cars and two homes worth almost a million dollars? How does he qualify for the mortgages on the two homes, and then buy a rental property with a substantial down payment and a mortgage? Simply evaluating his income tax returns will never provide the full story on his finances. Instead, an analysis of his monthly expenditures on the cars, homes, rental properties, and other living expenses will be more indicative of his true level of income.

What about the real estate developer who claims that his twenty commercial properties are all under water (the debt exceeds the value of the assets) and that he derives no income from the real estate business? His income claims appear to be supported by his income tax returns, which show substantial losses each year.

An analysis of his personal bank and credit card accounts show that the developer is spending approximately $20,000 per month on living expenses. How is he funding this lifestyle if he has no income? Could he be funding his lifestyle from assets such as savings and investment accounts? The records show that his assets are not being depleted. The records also show that he has not incurred debt to fund his lifestyle.

It is possible that the developer’s lifestyle is being funded from undisclosed income. While his real estate ventures may show losses on the income tax returns, this may simply be related to the tax treatment of real estate investments. That is, substantial deductions are allowed relative to real estate, often resulting in little or no taxable income. However, the real estate investments are likely generating substantial cash flow which he uses to support his lifestyle.

With enough information, a lifestyle analysis can be fairly precise. Estimates are required when there are gaps in information, such as missing months of data or known expenditures which are not documented on bank or credit card statements. The forensic accountant must look for outside pieces of information that can support any estimates or assumptions used in the analysis.

Methodology

A lifestyle analysis begins with an examination of documents in support of the expenses of the party, typically for a period of two to five years. The period selected will depend on the preference of the parties. A longer period gives a better picture of the long term, but it may not be reflective of the period immediately prior to separation and it may not reflect more recent changes to the lifestyle. The budget for the project will naturally play a part in the period selected for analysis.

The documents examined will include things like bank statements, investment account statements, mortgage statements, income tax returns, credit card statements, auto purchase documents, home sale or purchase documents, and invoices for home repairs. Hundreds of items could contribute to the lifestyle analysis, but these are some of the most common.

It is important to note expenses that will not recur, such as a wedding or an anniversary party. Gifts to family members or vacations may not be recurring, or may be reduced or eliminated following the divorce. Expenses that are incurred only occasionally, such as an automobile purchase, should be noted as well. The forensic account should also identify expenditures related to vacation, entertainment, and recreational activities, examining them over a period of time to understand normal patterns.

Basic personal finance knowledge can help the forensic accountant make reasonable estimates of other spending. For example, gasoline and groceries are two common personal expenditures that occur on a regular basis. If documentation shows unusually low figures for these amounts, it may be necessary to try to estimate a reasonable figure. Gasoline spending might be estimated based on the spouse’s commute to work, the number of car drivers in the household, and personal activities that require driving. From this, mileage can be estimated, and along with historical prices of gas, an estimate of spending on this item can be made. Grocery expenses can be estimated based on the size of a household, age of the children, and frequency of dining out.

Mortgage payments are typically made monthly, and real estate taxes are often paid annually. If this pattern does not appear in the documentation, it could signal missing statements or an error in analyzing the data. This type of review is necessary after tabulating expenses to spot potential errors or omissions.

Using known facts and common sense assumptions, estimates of other spending can be made as well. When estimating expenditures, it is important to consider the historical spending of the person and household. Significant changes in spending patterns should be carefully analyzed to determine if there is a reasonable explanation for the change, or if the change is reflective of hidden income. Categories that sometimes show unusual changes when there is unusual behavior include travel expenses, dining out, clothing, or entertainment.

It may also be necessary to analyze expenses to determine if they are for a non-marital purpose. For example, money spent to entertain a mistress or view online pornography may arguably be for non-martial purposes. These types of expenditures may need to be highlighted in the lifestyle analysis if the forensic accountant is attempting to determine financial needs following the divorce. Such items may also give rise to a claim of dissipation of marital funds.

After examining the available documents, the forensic accountant should look for undocumented spending. This type of spending is often found based on tips from insiders or circumstantial evidence, such as text messages or pictures on social media. People in-the-know might be able to point the forensic accountant to vacations taken, vehicles purchased, or other business and recreational interests that cost money but have not been known to the spouse.

The totality of the party’s expenditures is compared to the reported sources of income, and the forensic accountant should evaluate other potential sources of cash. Legitimate sources of funds could make up the difference between income and spending. However, if spending still exceeds known sources of funds, it can be inferred that the party has unreported sources of income.

Business Interests

Owning and operating a business can make the lifestyle analysis more difficult. The spouse who is active in the business likely has an opportunity to manipulate the finances of the business during the divorce to conceal income. This may have a direct effect on the asset division, since income of the business will be an important factor in the business valuation. It will also affect calculations related to maintenance and child support, as the income available for support is unfairly depressed.

In the case of a closely held business, it will be important to examine the accounting records in detail. The forensic accountant may find blatant instances of manipulation, such as the owner causing the business to pay for his or her personal expenses. This reduces the net income of the business, and also reduces his or her need to draw a salary from the business.

The detailed accounting records can provide a wealth of circumstantial evidence about the business too. The forensic accountant may find that longstanding customer relationships seem to have vanished, possibly as a result of the spouse hiding the revenue from that customer during the divorce proceedings. Evidence of large payments to new vendors could signal an entity established by the spouse to divert funds, while making those transactions appear to be legitimate business expenses.

Costs that move in step with revenue can provide important clues to unreported income. If the historical costs have had a fairly predictable relationship to revenue on a percentage basis, a significant change in this percentage after separation may signal unreported income.

For example, suppose a doctor claims that revenue is down due to a decreased patient load. However, the laboratory expenses have typically averaged about 4% of revenue. Following the separation, laboratory expenses were 15% of revenue. This could indicate that unreported revenue exists. Often, the business owner will conceal revenue while still reporting all expenses, and an analysis of percentages may hint at such a scheme.

The financial statements of a restaurant likely show a predictable relationship between revenue and food and beverage expenses. A manufacturing operation usually has a predictable raw material cost. A professional services firm often has payroll costs that are tied closely to revenue. Predictable relationships like this are not definitive proof of a scheme to defraud a spouse, but they are one bit of evidence that may help, especially if there is other evidence of fraud in the divorce case.

Down to the Penny?

Situational factors can affect the reliability of a lifestyle analysis. The receipt of gifts or loans from third parties could constitute legitimate sources of funds, but it may not be possible to factor them into the analysis if they are undisclosed. The forensic accountant should make reasonable attempts to determine if these exist.

It may also be difficult to account for personal expenses or other benefits, such as a vehicle that is provided by a business. These items ultimately are income to the individual, but lack of documentation makes them difficult to consider. It is not uncommon for the owner of a closely held business to reduce or eliminate his or her paycheck, while causing the business to pay for most or all of his or her personal expenses. This highlights the need to dig deep into the business finances in some cases. It is impossible to find evidence of these kinds of financial moves without getting into the account detail behind the income tax returns and financial statements.

It is nearly impossible to calculate the spouse’s exact income based on a lifestyle analysis. However, that should not deter the other spouse from having a lifestyle analysis completed. The calculation is done when there are suspicions or allegations of undocumented or unreported sources of funds and/or to document the parties’ standard of living over time. It is only natural that there may be some unanswered questions or imprecision in the calculation. Even if income cannot be calculated exactly, it may be sufficient to show that the income of the party is substantially more or less than what has been reported to the family court.

Judges understand that it might not be possible to precisely calculate income, and if all available documentation was analyzed and reasonable estimates were made when necessary, weight and credibility may be given to the analysis. At the very least, the judge is presented with an analysis that shows the spouse has not been truthful in disclosing sources of income.

Further, judges generally possess common sense. They understand that a spouse cannot live a lifestyle costing $20,000 per month without a source of funds. If loans, inheritances, and depletion of assets have been ruled out, the likely inference is an undisclosed income stream. They realize that the source of income might be more or less than $20,000 per month, but that this figure is a reasonable ballpark of the income.

When done properly, the lifestyle analysis can yield some very valuable information when the claimed income differs substantially from the lifestyle of the spouse.